Low capitalization rates for many high-quality senior housing transactions has made for a “seller’s market” the past several quarters. But senior living buyers may become more cautious as interest rates climb following rises in 10-year Treasury yields.
In mid-June, Ben Bernanke, chairman of the Federal Reserve, announced plans to taper off the quantitative easing program—through which the Fed spends $85 billion a month buying residential mortgage-backed securities and Treasuries—later this year.
Bernanke’s comments rattled the markets, which dropped about 4.3% in the three trading days after the announcement. By the end of July, the 10-year U.S. Treasury yield had jumped 100 basis points to 2.6% from January 1, 2013.
A former approximately 600 basis point spread between the 10-year Treasury and cap rates for independent living, assisted living, and memory care has shrunk significantly, says Scott Stewart, managing partner at Washington, D.C.-based Capitol Seniors Housing, a real estate private equity firm.
“That’s narrowed dramatically after Bernanke’s comments and the 100 basis point tick-up on 10-year Treasuries,” Stewart says. “After those comments, you saw the share prices of the big three REITs [HCP, Inc., Ventas, Inc., and Health Care REIT] fall pretty far off of their two-week high.”
Senior housing-focused REITs will likely proceed in caution as acquisition and refinancing costs grow, he predicts, whereas before they were growing rapidly to achieve scale. “I think it’s directly attributed to [the change in rates].”
It’s possible the 10-year Treasury rate will recede, Stewart says, but if not, the senior housing space will probably see a rise in cap rates that will swing the market to favor buyers over sellers.
However, rising interest rates aren’t expected to impact cap rates too much in the near term, says John Cobb, executive vice president and chief investment officer at Chicago-based Ventas (NYSE:VTR). They’re stable for now, with pricing remaining where it was a month prior, he said during SHN’s 2013 Senior Housing Summit in July.
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“General real estate pricing doesn’t move in direct correlation with the 10-year Treasury like it probably should, but eventually it will,” Cobb said. “If the 10-year goes to 3% in the next six months, you’ll probably see cap rates rise a little.”
Higher rates won’t necessarily have a negative impact across the board.
Rising interest rates won’t diminish Dallas-based operator Capital Senior Living’s returns by much, according to CEO Lawrence Cohen. Expected returns will continue to remain above 17% at current rates, he said during the company’s second quarter earnings call.
While the interest rate environment may have caused more transaction activity, he said, it hasn’t changed what sellers are expecting to get for their assets. Part of that may be tied to the quality of the properties.
“The quality assets are better. They’re higher margins, higher average rent, very stable occupancies,” Cohen said. “But the cap rate and kind of returns are almost identical to what we’ve been buying over the last two years.”
Rates today are still historically low, he added, while cap rates in senior housing remain higher than in many other asset classes. And whether it’s a buyer or seller’s market, there could be another positive in rising rates.
“The other phenomena that I’d like to talk about, which no one really addresses, is if interest rates continue to grow, cash flows in this business will grow exponentially because we serve a senior on fixed income, that for years now has received no return,” Cohen said.
High attrition rates from “financial move-outs” Capital Senior Living (NYSE:CSU) experienced in 2010 and 2011 have trended downward, and the company has been able to implement 2.5-3% annual rent growth for existing residents whose investments weren’t getting much return.
“Historically, this industry would get 4% to 5% rent growth. And if you compound that out over time, the cash flows on properties at a higher rate of growth in average multi-rate will more than compensate for any change in interest rate,” Cohen said. “So we think that this is an asset class that performs extremely well because there is need-driven demand, limited supply and really is almost insensitive to modest changes in interest rates.”
Written by Alyssa Gerace